Macro: Sandcastle economics
Invest wisely in Q3 2024: Discover SaxoStrats' insights on navigating a stable yet fragile global economy.
Access both platforms from your single Saxo account.
What are bonds? A very brief introduction
John Hardy
Chief Macro Strategist
Bonds are a class of debt securities issued by governments and companies that typically pay out a pre-defined cash flow to holders, called its “coupon”. On their date of issuance, the vast majority of bonds have a maturity date, a date in the future when the bond holder will be reimbursed the full face amount of the bond. That face amount at maturity is called par and is expressed at a price of 100 for the bond, i.e., 100% of the face amount. A bond can trade both well above par and well below par depending on a number of factors, like the size and of its coupon relative to prevailing interest rates, the timing of the coupon payout, and the credit quality of the government or company issuing the bond and other factors.
There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.
In order to judge the “quality” of a specific bond, the bond will be rated by a so-called credit rating agency, where the three dominant players are Moody’s, S&P and Fitch. The quality of a bond generally refers to how likely it is that the bond issuer is able to services its obligations to the investor in terms of paying coupons, paying back the loan at maturity etc. Bond ratings are split into two main categories – investment grade and non-investment grade/high yield/junk. Investment grade is high quality bonds where you get a lower return and take on less risk according to the rating, whereas high yield is where you get a higher return and take on more risk.
The different credit ratings from the different agencies can be seen below.
There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.
In order to judge the “quality” of a specific bond, the bond will be rated by a so-called credit rating agency, where the three dominant players are Moody’s, S&P and Fitch. The quality of a bond generally refers to how likely it is that the bond issuer is able to services its obligations to the investor in terms of paying coupons, paying back the loan at maturity etc. Bond ratings are split into two main categories – investment grade and non-investment grade/high yield/junk. Investment grade is high quality bonds where you get a lower return and take on less risk according to the rating, whereas high yield is where you get a higher return and take on more risk.
The different credit ratings from the different agencies can be seen below.
Bills versus bonds
The shortest-term government fixed income securities that mature within a year of issuance are called bills. These are not issued with a coupon, but are instead issued at a discount to par. The interest is paid as a function of the progress toward the price at issuance and the appreciation of the bill’s price as time transpires toward maturity. So, for example, if the 1-year yield is near 4%, a twelve-month US T-bill would be issued just above a price of 96, paying no interest but maturing at 100 on the maturity date 12 months later. If the holder sold the T-bill after six months and interest rates are still near 4%, the seller would realize a price of close to 98, i.e., close to 2% actual appreciation for half a year, or an annualized yield of 4%.
Floating rate bonds/notes
Floating rate bonds are bonds with a variable coupon. The coupon is typically reset every 3, 6 or 12 months at some level, or spread, relative to a benchmark rate. That benchmark rate is often a short term interbank rate for 3 to 12 months like EURIBOR, ESTR, SOFR, CIBOR, etc., or even a central bank policy rate.
These bonds typically trade very close to par, as the coupons mostly reflect the yields in the market as they are often reset. Floating rate bonds are interesting for investors wanting to receive the short term market yields (like now where yield curve is inverted, meaning that short yields are higher than long yields) while trying to avoid the risk of significant capital losses. This is because floating rate bonds usually are less volatile. Floating rate bonds are also of interest for investors that want to benefit from rising short term interest rates.
Why trade floating rate bonds/notes? The primary reason to consider these is avoiding significant capital losses if you aren’t sure you will hold even shorter maturity bond investments to par, but also if you are very concerned that yields are set to continue rising aggressively. Floating rate notes are available from both governments, local governments (many of these with very high credit ratings) and corporations.
Latest Market Insights
Quarterly Outlook 2024 Q3
Sandcastle economics
-
-
Bonds: What to do until inflation stabilises
Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain inflation and evolving monetary policies.
-
Equities: Are we blowing bubbles again
Explore key trends and opportunities in European equities and electrification theme as market dynamics echo 2021's rally.
-
FX: Risk-on currencies to surge against havens
Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperform in Q3 2024.
-
Commodities: Energy and grains in focus as metals pause
Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities in Q3 2024.
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)